Investing In A Friend’s Business- What To Watch Out For!

Many people wrongly assume that investors buying shares in a company have an extra layer of protection if they are also a director.

Let’s assume two friends have an innovative business idea and set up a company. They ask you to invest some of your life savings into the company for a 20% shareholding and a seat on the board of directors. This seems a good opportunity and so you decide to invest. The company starts to do well and makes a very healthy profit.

Now let’s assume these two friends decide that as employees of the company they will award themselves large and profit suffocating pay rises.

You may think that you can object and protect your potential share dividends- after all you are a director with powers to act on behalf of shareholder interests. But you could be wrong.

Unless the company’s Articles of Association state otherwise (unlikely if your friends bought a standard ‘off the shelf’ company) the directors act by a majority. Your two friends can vote together and award themselves their pay rises despite your objections.

Once they hear your objections your friends may decide that you are not the kind of director they want on the board. So acting together your two friends may well resolve to dismiss you from your directorship and again, using their majority shareholding, will carry the day.

Understandably you may now want to sell your shares. After all your friendship with your fellow investors has probably broken down completely. You may face the problem that no-one else is prepared to buy your shares. The only potential buyers are your friends or the company itself and they are not prepared to pay anything like the amount you invested. After all, your friends’ pay rises means a decrease in the profits of the company. As minority shareholders have little control on the company’s decision making, their shareholdings can be subject to a substantial discount unless the company’s Articles of Association specifically state otherwise.

At this point you may look to the courts to redress the position. There are two main options. You can bring a new style derivative claim on behalf of the company against the directors. But to do so you have to show that they are in breach of duty and any order you get will benefit the company and you only indirectly. Or you can apply to the court on the grounds that your interests as a shareholder are being unfairly prejudiced. The court has a very wide discretion as to what it can order but is most likely to require the others to buy you out at a fair price. However going to court is not going to be easy. It will take time, be costly and may not be successful.

All these problems would have been averted if the right Shareholders Agreement was in place or new Articles of Association were adopted before you invested.

For more information or advice, contact Richard Coombs.

Published 07/01/2008. The author of this article is Richard Coombs